October 14, 2016

Risk and regret

Which would you rather do? Try something risky with a potentially huge payoff, but which might result in a spectacular failure, or pass on acting now and wait for a less risky opportunity without the prospect of such a huge potential payoff to come along? ,

In the abstract, except to acknowledge that we never want to implode, this question is really impossible to answer. We don't have any idea of the risk of failure, nor of the cost of current inaction, nor of the likelihood of another, less risky opportunity appearing.

But that's the point, right? Often in life we are operating blindfolded, or at least with clouded vision and little foresight. We need to make choices when we seemingly are ill-equipped to do so.

AVOIDING BEARS AND CLIFFS

Our genes and our socialization favor us to be risk averse. Our distant ancestors learned and we know that jumping off of cliffs and running toward bears usually does not work out well.

It's proven that we take mental shortcuts, have biases and are ensnared by mental traps that lead us away from taking risks, whether we know it at the time or even in retrospect. This conservatism often protects us and at other times is not necessarily bad, except that as a result we sometimes spurn pursuing options that can change things for the better.

Take the case of the bear and the cliff: What if the bear is chasing us to the edge of the cliff? Then what? If deep water is not far beneath the cliff, jumping probably is wise.

When we look, we can find cases where seemingly high-risk actions have produced spectacularly good results. Several examples:

Elon Musk selling PayPal and sinking all of his wealth into Tesla and SpaceX.

Barack Obama, a relative political unknown, tossing his hat into the ring for the U.S. Presidency.

Pandora's top 50 employees agreeing to defer their salaries for two years until new investors came through.

Jeff Bezos giving up a great job to start selling books online from his garage, which he then grew by ignoring conventional wisdom into Amazon, the biggest online retail outlet.

HOW WE ARE MISDIRECTED

These examples of risk and great success may be outliers. But it's clear from research by psychologists, sociologists, behavioral economists and others that our mental shortcuts, biases and mental traps don't just protect us from "bad" risks, they can misdirect us, leading us to avoid "good" risks that are likely to take us down a better road.

Our thinking is skewed away from a dispassionate weighing of options. We are prone to overweight present, immediate, gratifying, clear and more certain options versus longer term, delayed and deferred options that may yield much greater benefits but hold the possibility of loss.

Consider how we are affected by this litany of shortcuts, biases and traps:

Hyperbolic discounting (also called current moment bias and present bias). We tend to have a stronger preference for immediate rather than for later payoffs. We make choices today that our future selves would prefer that we would not have made. We find it difficult to see ourselves in the future and to alter our current behaviors and expectations to have a better future. We often opt for current pleasure and leave the pain for later. We opt to spend rather than save, and snack rather than eat properly. Our organizations tend to opt for short-term gain (for corporations, quarterly returns) rather than long-term sustainability.

Impulsivity. We tend to choose an immediately gratifying option at the cost of long-term happiness.

Loss aversion (also called loss avoidance). When directly compared or weighed against each other, losses loom larger than gains. We pay more attention to avoiding loses than on gaining things. Nobel Prize winning psychologist Daniel Kahneman explains in Thinking Fast and Slowthat organisms that placed more urgency on avoiding threats than on maximizing opportunities were more likely to pass on their genes. That's why the prospect of losses has become a more powerful motivator of behavior than the promise of gains. We are programmed to favor a sure thing for a lesser gain over the high probability of a greater gain because we fear disappointment. Conversely, a sure thing for a smaller loss - accepting an unfavorable legal settlement, for instance - is preferred to the low probability of a greater loss because of fear of a large loss.

Ambiguity effect. We tend to choose the option that has a clear probability rather than that for which the probability is less clear because of missing information. "Better the devil we know than the one we don't" goes the thinking.

Certainty bias (also called zero-risk bias). We prefer to take action to reduce a small risk to zero rather than choose an action that produces greater reduction in a larger risk but does not eliminate it.

Default option. Doing nothing has a powerful draw because, well, we don't have to do a thing to pursue that option. Richard Thaler and Cass Sunstein write in Nudge, “If, for a given choice, there is a default option...then we can expect a large number of people to end up with that option, whether or not it is good for them.”

Ellsburg paradox. People prefer a known probability of winning over an unknown probability of winning even if the known probability is low and the unknown probability could be a guarantee of winning. Explaining the Ellsburg paradox, Dr. Daniel Crosby writes in Psychology Today, "We are programmed to choose safety, even at the expense of joy, in an environment where safety abounds and joy is hard to find. Numerous studies have shown that people are twice as upset about a loss as they are pleased about a gain."

Pseudocertainty effect (also called the illusion of certainty). An action-inhibitingresult of this effect is that we tend to make risk-averse choices if the expected outcome is positive.

Myopic loss aversion. When people assess their wins and losses over short periods, they become more risk averse and tend to opt for less risky investments. The idea is that frequent evaluations prevent the investor from adopting a strategy that would be preferred over an appropriately long time horizon. Evidence supports the view that when a long-term time horizon is imposed, people elect to take more risk for future gain.

Negativity Bias (also called the status quo bias and system justification). We tend to normalize our current situationas our reference point. This biases us to view deviations from this point as riskier, less desirable, or simply too much eﬀort.

Omission bias. We humans tend to judge harmful actions as worse, or less moral, than equally harmful omissions or inaction.

Ostrich effect. We are good at ignoring an obvious negative situation.

Persistence of commitment (also known as sunk-cost fallacy). We tend to persist in an activity even when the prognosis is poor, because of our past investment of time, money or effort. We feel the need to keep justifying our past decision to engage in the activity. And when we keep investing, we are then escalating our commitment to something which is failing or at least sub-optimal.

Probability neglect (also known as risk blindness). Our inability to gauge risk can lead us to overstate the risks of relativity harmless activities and therefore make us less likely pursue them.

So why do we ever take "good" risks?

REGRET IS POWERFUL

One answer is regret. Regret is a powerful emotion. We don't want to feel regret and seek to avoid it. We not only can feel regret after making a choice, regret that we did not choose what might have been a better option, but we are capable of forecasting our future regret and of taking action now to avoid future regret for not acting.

Of course, pursuing an option because we anticipate regret if we don't act does not assure that the choice we make is a "good" risk. Properly assessing the risk and potential return of an option and and whether we act on the option are separable activities. So if regret can get us off dead center and lead us to act, it does not remedy how our mental biases, shortcuts and errors, including those previously listed, hinder clear-eyed risk assessment.

A telling example of the power of regret is how many of Bernie Madoff's investors chose to invest with him because they thought they would regret not taking the transient opportunity when it was open to them. It turned out, of course, that by not properly assessing the option and pushing it aside, their investment in Madoff's Ponzi scheme self induced much greater future regret.

MOTIVATION AND CHOICE

Psychologists and sociologists have identified other motivators besides regret that lead us to choose to act, including fear, anticipated pleasure, anger, frustration, desire for power, wanting to belong and wanting to achieve. But, as with regret, any motivation to act in and of itself does not assure that any action is wise, or that the action we chose to take will have a good outcome or that the option pursued is the best choice.

In fact, while the various mental shortcuts, biases and mental traps cited above contribute to our generally risk averse nature, there is a companion set of shortcuts, biases and traps that can lead us to choose options and act when it is not in our best interest to do so. These include:

Fading affect bias. The emotion associated with unpleasant memories fades more quickly than the emotion associated with positive events, therefore making us overly prone to repeat actions that will not have good results.

False causality. We can falsely connect an action with a good result, and then are more likely to repeat the action, even though it will not yield the result we are expecting.

Illusion of control. Because we tend to overestimate how much we influence external events, we take actions that we believe will be effective when they will not be.

Positive outcome bias (also called optimism bias and wishful thinking). We can be over-optimistic. This can lead us to choose an option that is unwise because we overestimate the likelihood that it will produce a favorable outcome.

Positive expectation bias. We act because we sense that our luck will change for the better, even when there is no basis for our conclusion since we have no control over luck.

Power. The sense of control that those who are in positions of power have tends to make them overconfident in their ability to make good decisions and to overestimate the accuracy of what they think they know. This can lead the powerful to take greater risks.

Illusory superiority. We are prone to overestimate our desirable qualities and underestimate our undesirable qualities relative to other people, leading us to think that we can make better choices than others can.

Risk seeking. When we are in a losing situation, we are prone to bypass the opportunity to limit our loss and instead up the ante to chase the chance of a big win, thereby increasing risk.

Pseudocertainty effect (also called the illusion of certainty). An action-promptingresult of this effect is that we tend to make risk-seeking choices to avoid negative outcomes.

Scarcity heuristic. We perceive opportunities to be more valuable when we think they are rare or limited and thus are prone to pursue them when it is not in our best interest.

Gambler's fallacy. We tend to overweight the effect that we think past events will have on future outcomes (or predict an effect when there will be none, as in the case of thinking a coin is more likely to come up heads when a series of previous coin flips have yielded tails).

Hot-hand fallacy. We sometimes mistakenly pursue options because of a false belief that a person who has experienced success has a greater chance of success in added attempts.

Irrational escalation (also know as the Concorde effect). This is an extreme outcome of the sunk cost fallacy, in which we go beyond just justifying our previous investment to double down and increase our commitment to it.

Probability neglect (also known as risk blindness). Our inability to gauge risk can lead us to understate the risks of dangerous activities and outlier events and therefore make us more likely to pursue them.

IMPROVED ASSESSMENT AND ACTION

Escaping the adverse effects of our mental traps, biases and shortcuts is difficult and sometimes impossible. The good news is that even with all of these trip wires, dead ends and miscalculations in our heads, we often make good decisions and pursue reasonable risks.

But why not try to improve our risk assessment and choices to the extent possible?

Research suggests steps that we and our organizations can take to better assess the risks and potential payoffs of our options - and that can help us act when the risk/reward equation is in our favor and hold back or choose another option when it is not. We can:

Raise our awareness of the need to recognize situations when an important decision with significant consequences is at hand.

Slow down our decision making and avoid impulsivity and immediate gratification at these important decision points.

Look for more evidence before putting stories around our options (imagining how things might work out).

Seek alternative explanations for what the evidence might say to us about risk and reward.

Recognize the default option and work to counter its powerful allure.

Look for sunk costs that call us to justify, persist in and even escalate our investment.

Have others challenge our thinking by offering an outside perspective for us to consider.